Prognostication

OCTOBER 2008

The Bailout and the Real Estate Market—Softer by the Day!

by

Dr. Mark Lee Levine

 
 I.         INTRODUCTION:  With 3/4ths of 2008 behind us, many of our prior projections for 2008 as to performance in the market were on target, while some prognostications were off target, and some resulted in mixed conclusions.  An economist might have concluded in early 2008 that the overall real estate market in 2008 was “staged” for good performance in the U.S., assuming that major events did not occur (such as substantial rise in interest rates, escalation of war, breakout of new conflicts, more terrorism, etc.). Of course, the thought was, by some, back in 2007, that the residential market would be “back” in 2008.  The consensus by many economists, today, for the residential market is it is unlikely to be on solid footing until sometime, at best, in 2010.  That is, 2009 will be, at best, a recovery year.  And, other types of real estate, e.g., commercial real estate, is facing a difficult time in 2008 in many areas of the country, especially because of the financing hurdles that face many proposed sales and developments today.

            This overview consists of economic predictions, prognostications, and other projections, and includes complex interactions of multiple factors that influence, direct, and impact performance of all global economies. However, two (2) specific real estate projections garner a good deal of agreement:

            1.      “The U.S. Residential market, overall, is not doing well.” — This may be one of the more understated comments of the year for the Residential market; and

2.      “The U.S. Commercial market is beyond “possibly showing signs of slowing in 2008.”  The Commercial Market has slowed in many areas of the field; and, look for more problems later in 2008 and continuing in 2009, exacerbated by financing concerns and the weak overall financial markets.  (The ‘Bailout’ activity will influence this area and most investments.)

           Terms employed by economists may euphemistically refer to noticeable changes in the economy as “fluctuations,”  “hedging” and/or "corrections."  However, terms for substantive changes within the marketplace may include “recession,” “depression,” “recovery” and/or “expansion,” among other terms.  (When the direction of the market is generally down, the phrase might often be characterized as an “adjustment.”)

@   Copyright by Dr. Mark Lee Levine, Denver, Colorado 2008.  All rights reserved.

II.        THE GENERAL MARKET:  BROAD SCOPE:   Many subsets in the real estate market include major divisions between residential real estate (single-family or multi-family), and commercial real estate (offices, retail shopping centers, hotels/motels), etc.  There are further divisions within each of these areas.

         In examining geographic areas with the U.S. market, overall real estate market prognostications for the Western part of the U.S. might perform well, while some markets in the North Eastern part of the U.S. may be performing very badly; the opposite positions may also apply.

         The following comments hopefully provide some insight as to what the Author generally concludes as to the overall current market conditions for the coming months.

III.    THE U.S. RESIDENTIAL HOUSING MARKET:    Regarding performance of the U.S. residential real estate market, it is very clear that indicators from the National Association of Home Builders (NAHB), National Association of REALTORS® (NAR), and many other leading sources, show signs of significant slowing and/or decline in various areas.  When comparing market data from the last few years in the U.S., these areas include increasing inventories of unsold new and existing housing, a slowing of the issuance of permits for residential construction in most areas of the U.S. poor performance of the sub-prime lending market, more real estate foreclosures—in absolute numbers and in percentage increases in foreclosures, and an overall slowing of the residential real estate market.   Many reasons suggested for this slowing in the marketplace include an oversupply of housing, reduced demand for housing, changes in the mortgage market (increasing requirements to qualify for loans), limits on available financing, increasing concerns faced by many lending institutions that have been too aggressive in their loan and financing practices in the last few years, etc. 

           Although reported core inflation had been “down” (excluding food and energy), in early 2008, the market is not free from the concern of rising inflation, along with the other points noted above.  Inflation seems to be rearing its ugly head; and, aside from some relief in the pricing of oil, which continues to have large swings in the pricing, it is likely that inflation will continue an upward trend for the end of 2008 and in to 2009, at the very least.

         Of course, as the market continues to decelerate in the Residential area, there are many concomitant adjustments that tend to pull the market back up to a more positive outlook.  The lowest interest rates in decades have moved the market forward.  However, recent identification of events of financial struggles and failures created many new problems since September, 2008.  Consider such events as the Subprime fiasco, entities such as Fannie Mae and Freddie Mac, AIG, Lehman Brothers, Bear Stearns, Goldman Sachs, Merrill Lynch, the auto industry in the U.S., major banks (Washington Mutual, Wachovia, etc.), and so forth, as to the many financial problems that have been recently identified—and this is only in the U.S.A.  (Many of these same financial issues, without regard to addressing cause-and-effect, are also prevalent outside the U.S.A.)

The opportunity for a buyer to acquire a home, with a good selection, at a reduced price, with a low interest rate, and “extras” (incentives) provided by builders and sellers of existing homes can act to entice the somewhat reluctant buyer to consider a home purchase.  Tax benefits provided by Congress and the President in February, 2008, and even more recently with additional acts, have provided additional incentives and funds for consumers to encourage consumer confidence and business activity.  This assumes that the consumer has the financial ability to make the purchase.

IV.    CONSUMERS—CAN THEY KEEP THE ECONOMY MOVING?

             Even with the 2008 tax incentives, the average consumer cannot continue spending at 2007 levels.  During the last few years, many consumers, especially homeowners, refinanced their real estate with Adjustable-Rate-Mortgages (ARMs) and short-term loans.  Many of these consumers are now facing, in some instances, the need to repay such borrowings as the loans have come due or are adjusted, upward, as to the interest rate and the monthly payment.  Many homeowners have found that they are not able to repay the debt, which debt now carries a higher interest rate.  Or, if the debt can be repaid, it is with much pain—and many constraints on pocket books of consumers.  Hence, other discretionary spending has been reduced.

            Increased foreclosures in residential markets are apparent throughout the U.S., e.g., Colorado, California, Arizona, Nevada, Florida, and Texas, among others.  Often these foreclosures generate concurrent bankruptcy filings.  Such positions do not embolden additional borrowing and additional consumer spending. 

V.        U.S. STOCK MARKET:   As much as one can say on the negative side for housing, it is very clear that the U.S. stock market, and markets in other parts of the world, e.g., China, have fluctuated, significantly, up and down, setting new records.  However, not all news is Bull news.  In February, 2008, many markets in the U.S. and outside the U.S. hit a brick wall and suffered substantial reductions.   The DJIA moved in the range of 12,000; the NASDAQ was in the area of 2,200, and the S&P was in the 1,200 range.  True, there were moves up—as well as down.  However, the robust market of 2007 quickly faded.  And, in September, 2008, the ranges, noted above, looked very good, considering that the DJIA moved to above 10,000; NASDAQ and SP also continued to drop, even with a few spikes during the last 1/3 of 2008.

            As noted above, many major banks and principal investment firms struggled to stay in business, to merge, or to make other huge changes in ownership and in their structures.

            The U.S. stock market, overall, remains encased in fluctuations.  Does this foretell a positive position for the real estate market?  Some argue it does, as this provides capital in the marketplace and a positive outlook.  However, some funds will move to other markets in the form of cash, stocks, bonds, or in other investments; but, surely, it has been argued, some of the funds will move to real estate, to balance the portfolios of investors, large and small.   Part of the fear is that some of these funds, with hot money, will move outside the U.S., searching for better returns and possibly a safer haven.

            As I said in an earlier Note on this web site:

            “A recent Survey, undertaken by the National Real Estate Investor and Marcus and Millichap Real Estate Investment Brokerage Company, noted that 7 out of 10 respondents in the study indicated they want to increase their investments in real estate in the next 12 months, ‘notwithstanding lower yields.’ ”

            “Alternative investments are lacking in many instances; therefore, there is an attraction to the real estate position, including the hoped-for position that lower interest rates are attractive when coupled with the potential of appreciation in real estate values in a few years.”

          But, maybe we should not be so sure that the funds will be moving to the real estate side, given recent slowing in the commercial real estate market, especially because of more difficult underwriting requirements.  If funds are not available because lenders face “Market to Market” considerations, other underwriting controls, capital requirements, and much more, look to see real estate continuing to struggle to gain financing for transactions.

 VI.  THE U.S. COMMERCIAL MARKET:

            As the residential real estate market weakened in most parts of the U.S. in the latter part of 2007, the U.S. commercial market over 2007 was, generally, very strong.  Most sectors of the commercial market, including office, retail, hotel, apartments, industrial, and other investment segments in the commercial field, were strong in the first ½ of 2008.  As for 2008, with normal hedges having been stated--that is, with all else remaining about the same-- it seemed likely that the commercial market would level or slightly decline in 2008.  However, given events in the latter part of the third quarter of 2008, it is clear that the words “slightly decline” were too mild.  The commercial market slowed much more rapidly than many leading economists suggested.  Why?  Some argue that the many factors noted above, coupled with elections, election uncertainty and the uncertainty of U.S. leadership, have added to issues of concern.  The weakening dollar, the continued concern with the Iraq war, and numerous other factors create doubt in the minds of U.S. and foreign investors.  And, the enormous debt load in the U.S., given the failures of institutions, noted above, the war, price of oil, and much more have added to this uncertainty.

            The commercial market is competing for part of the capital market which is utilized for generation of return on the investment.  Investors (large and small) need to invest capital, with proper diversification, in various portions of the investment market that will produce the greatest returns, balanced against the concomitant risks in investments.  Thus, as long as capital is seeking a home to generate return, there is interest to invest in U.S. markets.  But, given the weakness in the U.S. financial market, debt structure, loss of consumer confidence, and other negative factors, the pull toward U.S. real estate is not nearly as strong as one might have predicted would be the position, when looking forward from 2007.

            In summary, activity in commercial real estate in the U.S. has been slowing during the last 1/3 of 2008.  It is almost a certainty that such slowdown will continue for the balance of 2008 and most likely for all of 2009.

VII.     SO, WHAT ARE THE CONCERNS?

            In a prior Note on this web site, I noted a Study indicating some of the areas of concern in the real estate market.  There is merit to consider these factors on an on-going basis.

            The areas of greatest concern to respondents involved in the above-referenced Real Estate Investor Outlook Study included: 

            1.         RISING INTEREST RATES:  This is the most important concern by about 62% of the respondents.

            2.         UNFORESEEN SHOCKS TO THE ECONOMY:  Similar to the interest issue, this was an important concern by the respondents.  And, this factor was raised PRIOR to the failure of Fannie Mae, Freddie Mac, AIG, Lehman, etc., that have arisen in the latter part of 2008.

            3.         SLOW PACE OF RENT GROWTH, ETC.:  This area was third, followed by concern for HIGHER VACANCY RATES and issues as to the CREDITWORTHINESS OF TENANTS.

          4.       VIABILITY OF INSURANCE, LAGGING PRICING, LOAN DELINQUENCIES and SECURITY OF BUILDINGS:   These issues were also of concern.

 

CONCLUSION:

            Many economists—over the years-- have predicted a strong economy, when often the economy was heading in the opposite direction.  The test is to determine which of the predictions are actually on track, as opposed to which prognostications are blinded by a desire of the “hope” that the general economy will do well.

           It is very interesting to compare positions of many economists, with hindsight. In an earlier article, I cited the position of one study which noted that 95% of the economists surveyed in 2001 said they saw a wonderful, growing economy.  But, in hindsight, AT THE TIME OF THE PREDICTIONS, the economy was already in a Recession!  This gives us little faith in not only the economists, but also in our own ability to forecast macro positions for the economy.  (Micro positions for one’s own business may provide a better opportunity to, reasonably, forecast the economic future.)

This same scenario may be applicable today.  While most economists seem to have been saying in early 2008 that the economy was “doing very well,” aside from residential real estate; and, the economy would improve in 2008, we have seen, for the latter 1/3 of 2008, some of the worst financial U.S. disasters in our history!

              Many commentators in the real estate market in early 2008 argued that because there has been a great deal of capital waiting to be invested; and, because investors have more recently been willing to accept a lower rate of return, at least from a cash-flow standpoint (with the hope for appreciation), there may be sufficient support in the commercial marketplace, at a reasonable pace, to bet on a “soft landing” for those areas that will face reduction in activity.  Given events of the last part of 2008, it is not likely that most prognostications would support a rosy picture of our economy.

And, as I said in March of 2008: 

 “I am not a pessimist.  I am a realist.  Given this proclivity toward realism, I doubt the ‘soft landing’ will be without a good number of big bumps.  (Many would call this description euphemistic, translating the comment to one of a ‘hard landing.’)  If the war, higher oil prices, lack of consumer confidence, uncertainty in the markets, the weak dollar, the decline in the residential market, import/export deficit, and a few more negative factors continue, as noted above, the ‘hard landing’ folks have the better side of the bet.”

             A fortiori:  If I was concerned with the economic setting in the first part of 2008, you can be sure that I am very, very negative on our current position.  With the failures noted earlier in this Note, it is, to me, a certainty, that our “recovery” has a long, long way to go.

                 

@ Copyright by Dr. Mark Lee Levine, Denver, Colorado 2008.   All rights reserved.

mxaPRO-3 Quarter-Prognostication

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            As a professor, my general approach has been to attempt to grade many areas within the marketplace.  Part of this grading for the market follows:

 GRADE:  FOR CURRENT POSITIONS:  SHORT-TERM:

 D         RESIDENTIAL (SINGLE-FAMILY, CONDOMINIUM, TOWNHOUSES, etc.): Sales of single-family homes have slowed in many areas throughout the United States.  There are weaker pockets for some housing in U.S. markets.  Increase in foreclosures, the slowing of sales and the reduction in those seeking building permits all point to reduced activity in the residential market.

B-      MULTI-UNIT RESIDENTIAL PROPERTY:  Vacancy rates have decreased in many areas, but other areas are seeing a leveling, or even a slight increase in vacancy rates.  It is anticipated that these rates will continue to drop in many markets in 2008.  If interest rates continue to rise, the affordability index for home purchases will fall – as has been the case in the last several months. This means that apartment vacancies should drop somewhat.  Clearly, the reduction in activity in the residential home purchase market spells the potential for activity in the apartment market.   However, financing limitations create restraint on adding units.

C       OFFICES:  The office market is suffering from the financing issues noted earlier.  It is likely this will continue into 2009.  Also, jjob losses and a weaker economy reduce the demand for office space.

C-       RETAIL/SHOPPING CENTERS:  Retail space was surprisingly resilient.  However, consumer confidence remains one of the big keys to success in this area.  Recent activity seems to support the position that consumers are slowing their spending in the retail area.  Retail sales are also impacted by job growth.  Clearly the retail sector has been hit in recent months with a negative position.  Major shopping center owners, via a REIT structure or otherwise, have seen a huge drop in the value of their stock positions, overall.  And, look for this to continue, given the other issues in the market place and low consumer confidence.

B-       INDUSTRIAL/WAREHOUSES:  Industrial/warehouse space seems to show a reasonable pattern of occupancy.  Although some pockets have increased vacancies, occupancy seems to be holding. 

B-       HOTELS/MOTELS:  Hotel and motel vacancy rates are dropping.  Some recovery is taking place at this time with hotels and motels, as well as increasing travel. However, if oil prices continue to increase, and, therefore, travel is impacted, this will adversely impact this area.   The general financial crisis will also dampen demand in this sector.

 B-        SPECIAL-USE PROPERTY:  Other special-use properties, such as in resort areas, are feeling, in some instances, consumer reluctance to spend on vacations and other special activities.

C-        FINANCING ISSUES AND RATES:  Affordability is more difficult in many markets, even though housing prices on the national level have been dropping from their highs of only a year ago.  Of course, the subprime market is a disaster.  Underwriting is more difficult. Foreclosures are a major problem.  Many of the financing markets are “frozen,” given the defaults, noted above.

C-        REFINANCING AND RATES:  A good deal of refinancing in the residential market has taken place.  Subprime and refinancing needs continue to create problems.  Underwriting is more difficult and rates are moving up.  With many financial failures, this area will continue to have problems.

            IN SUMMARY:   THE QUESTION:  “What will happen in the U.S. real estate market in the end of 2008, given oil prices, the war, interest rates, deficit spending, slowing in the housing market, defaults, bankruptcies, etc….?"  The answer, as usual, is:  “It depends on ….”  But, overall, the first part of the 2008 real estate market looked weak for residential, and “O.K.” for commercial property.  For the balance of 2008 and 2009, the outlook for real estate does not look good. Unless financing issues are corrected and positive, 2009 will not be a strong year for most real estate transactions—along with other financial transactions in the U.S.